OPTIMUM INCOME TAXATION WHEN EARNINGS AREIMPERFECTLY CORRELATED WITH PRODUCTIVITY

Probably the most enduring result in the theory of optimum income taxation is that,for a sufficiently thin upper tail to the skill distribution, the marginal tax rate shouldfall rather than rise with income. This paper shows that this result is highly sensitiveto a very strong informational assumption, namely that earnings exactly reflect aworker's contribution to output. While the formal structure of the optimum problem isaltered only slightly when earnings are allowed to be less than perfectly correlatedwith productivity, the shape of the optimum schedule is very sensitive to thisrelaxation. For high but imperfect correlation, optimum schedules look rather likethose traditionally chosen by governments, with the marginal rate rising over highincomes and possibly U-shaped over the whole distribution....